Balance Sheet is the Most Important Document
It is easy to get lost in numbers and a range of what if scenarios when evaluating stocks for investment. While the financial statements may be standardized for GAAP, each line item in these statements have a history behind it that is unique to the company in question. Sometimes one needs to go beyond the numbers to understand the business to determine if the stock in the company under consideration is worthy of investment. Investors often get bogged down in projections and estimates. However a balance sheet is real and known and presents a better indicator of value with data that is more likely to give us a conservative estimate of the value.
The Basic Philosophy of Value Investing
The idea behind value investing is simple enough – buy stock in companies that are selling below the intrinsic value and sell stock in the companies where the stock price has reached or exceeded the intrinsic value of the company per share. If you buy stocks at a sufficient discount, you minimize your risk of capital loss. Over time, the stock market does the rest and ascribes the correct valuation to the company stock, thereby providing investors a good return.
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How to Determine the Intrinsic Value of a Company or Stock?
We know the price of the stock. It is easily available from brokers and quotations from stock exchanges. The difficulty arises in estimating the intrinsic value of the stock. Since we are looking for stocks where the price is below the intrinsic value, it is quite critical that we estimate the intrinsic value conservatively. When done so, we might have to pass on a few stocks that might be good investments, but we also narrow down our investment universe to a few names that we can get to know better and will most likely yield the best value stocks that are available.
It is also worth remembering at this point that a good value investor pays less attention to what might be in the future for the company and much more attention to the current state of the business. Predicting future (such as growth rates) is a risky endeavor and more likely than not, the future is not going to be the same when you get there. Technology changes, markets change, competitors enter and leave, and many more things happen that we cannot know of in advance nor can we prepare for it. A case can be made for companies and industries that have a defendable market position due to certain competitive advantages (such as regulatory hurdle, branding, R&D, monopolies, or companies that operate in industries with fairly inelastic demand and large barriers to entry).
Steps to Estimating Intrinsic Value
Any value analysis should focus on those sources of value that are known with certainty first and than move on to those sources of value that are less certain. If you find that a stock is undervalued during the initial stages of your analysis when the numbers inspire greater confidence, you may not need to perform additional analysis. I am not one of those who go through all the analysis to establish an intrinsic value to a high degree of precision. At some point during the analysis, you start trading off precision with declining levels of confidence.
Start with the Balance Sheet First
Valuing assets and liabilities on the balance sheet is much less nebulous and most of the time you will end up with a valuation number that you can place a high confidence in. Being conservative investors we are, it is important to cast a skeptical eye on the asset values, with the aim of ascribing as little value to the assets that you can possibly do with good justification. Liabilities on the other hand can be taken at face value or in some cases increased, if you have a good reason to believe that all liabilities are not faithfully reported.
Step 1 – Ask the question what would happen if the company is liquidated today at fire sale prices
The only things an investor can be certain of in this scenario is that the cash and other current assets are probably worth $1 for $1. Possibly some of the receivables could go uncollected, so a little adjustment for that possibility is always wise. Also while raw material inventory might be fairly valued, work in process and finished goods inventory might need to be scraped so their value needs to be adjusted down. The debt holders though will collect everything that is owed to them. If the assets of the company are not enough to satisfy outstanding debt, than the shareholders will end up getting nothing.
Current Assets – Total Debt is called Net Current Asset Value (NCAV). If the stock price is below the NCAV, than the stock is undervalued. One can simply buy up the company at the current price, sell every thing, pay all the debt and end up with a value of NVAC for all the troubles.
Any value in the long term assets of the company is just the cherry on the topping.
While stocks like this are rare, we have uncovered quite a few of these for our members.
Step 2 – Ask the question what would happen if the company is liquidated orderly over the course of few months
If the liquidation process is orderly and done over time, the owners of the company are more likely to collect all the outstanding receivables, place the long term assets on the market and realize a good value on them. Additionally, a market can be found for WIP and finished product inventory and a good portion of it could be converted to value (above the scrap value).
You also want to discount all the intangibles and goodwill completely, unless there is a market for these assets (some patents, customer lists, etc may have some value)
In this case, you may add conservative estimates of these assets to your intrinsic value from Step 1. If a stock is not at sufficient discount to the intrinsic value in Step 1, it just might be when you finish the Step 2 calculations. To manage your risk, you may want to increase your required discount (also called margin of safety) from the intrinsic value in this step.
A Note about Book Values: Book Value is a popular ratio to screen for undervalued stocks. It does its job admirably to find potential stocks that you may want to research further. However, you need to understand that book value of a stock is often not reflective of the current market as valuation of many long lived assets could be significantly different than what the current market can bear. It is always a better idea to estimate the intrinsic value using the bottoms up approach.
What about the stocks that do not meet any of the above valuation criteria? Can there be such stocks that are undervalued? The answer is yes – there are situations where a company can generate above average profits using comparable resources or assets AND sustain that level of profitability over time. Such companies may be undervalued based on their earnings power. We will look at Earnings Power in Part II of this guide.